Storm Clouds: Recession Ahead?

Stocks in the US are reportedly off to their worst December since 1931. More saliently, most every market is now in “correction” (down 10%), with some markets and sectors already in a bear market (down 20% or more). Alongside this weakness, the yield curve has begun to invert in some areas, potentially an indicator of recession in 12-18 months.

Looking in the rear view mirror, economic growth in the US is healthy. Looking forward, however, investors see heavy storm clouds, and sentiment is getting increasingly negative. Recession wasn’t expected a few months ago, but it seems increasingly like a self-fulfilling prophecy, no?

OUR MESSAGES:

Recessions are inevitable over broad cycles. But you can’t reliably predict them. Instead, you need a disciplined approach that recognizes fundamental extremes and acts objectively, to keep the risk/reward goals of the portfolio in balance. For clients taking distributions, we already have a heavier defensive posture, by design.

For many stocks, a major slow-down is already expected and apparent—at least as reflected by stock prices. Stocks of banks, home builders, construction companies, raw materials providers, etc., are down 20%-30% already. Stocks typically react long before economists officially announce a recession.

How good or bad markets will be in 2019 essentially depends on important unknowns, such as: 1) whether the Fed will raise rates too aggressively; 2) whether trade wars between China and the US escalate; and 3) if key emerging markets like China see material downdrafts in their economies.

How might these wildcards play out? We offer some guidelines below.

Will the Fed raise rates too far?

We believe rates do need to rise to a more sustainable, normal level. Rates are very low by historical standards, with little “dry powder” as a policy tool to manage growth.

At the same time, we believe the Fed is mindful of the impact of equity markets on consumer behavior—a key driver of the economy. Stocks (and housing) create a “wealth effect” and can influence economic growth by half a percent, give or take. So we suspect recent broad weakness in stocks to temper the Fed’s actions, as necessary.

Our own assessment: we could expect another two or three rate hikes (including December) in the year ahead. Stocks might remain choppy, and shorter-term rates should rise, but we think this will be better for long-term policy.

Will trade wars escalate?

The impact of tariffs as currently announced should be manageable for world markets. But the concern is that the impact will expand, with rounds of protectionism that ultimately impede growth.

We believe China is in violation of intellectual property laws, so the US needs a policy response. For what it’s worth, we prefer coordinated diplomacy and collective sanctions by allies—rather than unilateral trade wars—to get China to comply.

The fact that China is willing to negotiate with the US over tariffs implies to us that China is more concerned about their national economy than they are admitting.

A weaker China means challenges to global growth, but the market is aware to some extent already.

The question is, “how much worse could it be?” Surprises (such as from adversely high debt levels in China relative to a real estate bubble; slowing retail spending and factory output, etc.) would be further negatives for investors.

The market was spooked when it learned that China announced it would stop reporting publicly several key economic indicators. What is the government planning to hide, so that they can fabricate an appearance of growth?

All-in, a protracted trade war is not in China’s best interest, in our view. This could keep retaliation in check.

Isn’t the US economy doing well?

On one level, the US economy seems to be doing very well. Corporate earnings are strong, unemployment is at historic lows, and real wage growth is finally picking up.

That said, recent housing data is showing weakness. Inventories of unsold homes have started rising across larger cities. This has also spooked investors.

A slowing housing market matters, because housing accounts for roughly 15%-20% of the economy (rent, utilities, and construction/remodeling).

All-in, we suspect the US may experience tempered (but not negative) growth in 2019, if international markets struggle and housing activity slows.

Based on this assessment, we would not expect recession per se in 2019, although economic growth for the US will likely be lower than forecast. What this means for us is that earnings for many stocks (even those down hard already) may still need to come down. The market is likely to remain volatile during this process.

We close with a high-level review of what our bottom-up research is showing:

Our investment models have called for adding incremental weight to Value[1]—initially over the summer, and a further addition over the past few weeks. Banks, capital equipment manufacturers, and other cyclical stocks are looking very cheap.

Emerging Markets continue to show some of the best valuations (about 11X trailing P/E, with 3% dividend yields), but near-term probably remain weak as the US Dollar strengthens and concerns over global growth prevail. We believe Emerging Markets have some of the widest value spreads, although it may be early to be aggressive.

The US market remains the most attractive in the Developed world, followed perhaps by UK, Singapore, Australia, and Hong Kong. Much of continental Europe remains less attractive currently, given challenges to economic growth.

We continue to focus on investment grade bonds with shorter maturities as rates potentially rise and avoid broader high yield bonds, where spreads have begun to widen already.

Any questions, please let us know.

[1] Recall that Growth and Value are two common investment styles. The Growth Style generally seeks to find companies that grow faster than the market, with less emphasis on earnings. The Value Style typically seeks companies that are “on sale” relative to their assets and long-term fundamentals. These styles tend to cycle around each other; over the past few years, the Growth Style has surged compared to Value, to a point that is unattractive, by our analysis. We follow the Value Style primarily. For more, see http://www.cornercap.com/insights/chart-month-extreme-market-growth-stocks .